Buy AIG To Profit Off Yellen

Summary

Janet Yellen signaled an increase in interest rates in about 12 months.

Higher rates will increase AIG's investment income and more deeply discount future claims.

With $6.25-$6.75 in 2015 earnings power, shares are very attractive at $50.

Markets did not react particularly well to Federal Reserve Chairman Janet Yellen's first press conference with the Dow Jones Industrial Average shedding 115 points, though the market did close over 50 points above the intraday low. When the Fed released its decision after a two day meeting, it did not seem all that surprising (statement available here). The Fed tapered asset purchases another $10 billion as expected and withdrew its previous forward guidance for a rate hike once unemployment fell to 6.5%. The market had already discounted this guidance as unemployment is currently 6.7% due in part to a drop in the labor participation rate. This statement was not all that surprising.

Similarly, the new economic projections were not surprising (projections available here). Due in part to the weather, growth estimates are slightly lower for 2014 with a central tendency of 2.8-3.0% down from 2.8%-3.2% in December. Core inflation expectations were unchanged at 1.4-1.6%. 13 out of 16 members said they expect to increase interest rates in 2015 with a central tendency of around 1%, which is not far off from what many market participants had been looking for. Why then did the market drop?

At the press conference, Janet Yellen struck a surprisingly hawkish tone. This is not to say she is a hawk; rather, she was far less dovish than many had assumed. One line in particular is important for investors to consider. Yellen was asked how soon after ending asset purchases would the Fed start to increase interest rates. She responded, "So, the language that we use in this statement is considerable, period. So, I -- I, you know, this is the kind of term it's hard to define, but, you know, it probably means something on the order of around six months or that type of thing. But, you know, it depends -- what the statement is saying is it depends what conditions are like." Investors can read a full transcript of the press conference here.

At the current pace of tapering, the Fed should stop buying bonds in about 6 months, which means that Yellen anticipates raising rates about a year from today. This is a bit earlier than I, and many others, had anticipated. I had been expecting about 15-18 months before an increase in interest rates, but it appears Yellen wants to start a bit earlier and move at a gradual pace to at least 1% by the end of 2015. That puts us on course for a 2.5-3% fed funds rate by the end of 2016. While higher rates were always inevitable, they appear to be a bit closer than previously assumed, which caused a bit of selling on Wednesday. Investors will be looking for companies that benefit from this new guidance for higher rates, and American International Group (NYSE:AIG) is poised to profit from Yellen's policy.

In general, the life insurance companies should benefit greatly from higher interest rates. When they write policies, they will have to pay a claim sometime in the future but start receiving premiums today. Insurance companies then invest these premiums in stocks and bonds to generate investment incomes. As long as underwriting standards are sound, premiums and investment gains can pay future claims and leave profits for shareholders. Moreover, a higher interest rate more steeply discounts future claims. In other words, liabilities have a lower present value while assets can generate more current income as rates rise. The sooner the Fed starts to increase the rates the better AIG and other life companies like MetLife (NYSE:MET) and Prudential (NYSE:PRU) will do.

AIG has begun to aggressively push back into life insurance and is doing so at a perfect time. In its last quarter, premiums and deposits jumped 54% to $8.04 billion (financial and operating details available here). The base investment yield of its holdings stands at 5.29% with AUM at $318 billion up a solid 10% year over year. Now, there is a negative to a sharp increase in interest rates as the value of current bond holdings will fall. So long as these bonds are held to maturity, a drop in price is irrelevant though. Excluding other comprehensive income (which is mainly unrealized gains on bond holdings), AIG has a book value of $64.28. In other words, AIG's entire bond portfolio could drop back to its cost basis, and AIG would still have a book value of $64.28, which is 29% higher than current levels.

Moreover because of its significantly growing life businesses, AUM should continue to climb, and I expect AUM to surpass $345-$350 at the end of 2014 with another $30-$35 billion coming in during 2015. Combine this premium inflows with bond maturities, and AIG will have a lot of dry powder to purchase higher yielding assets over the next two years. Based on Yellen's guidance, I expect base investment yield to be about 5.6-5.75% this year and 6.05-6.25% in 2015, which would increase earnings per share by over $1.50 and push AIG's return on equity past 10% in 2015.

AIG is moving into life insurance at precisely the right moment. Its increase in life underwriting will coincide with higher rates, which increases investment income. AIG should generate about $5 in earnings this year and $6.25-$6.75 in 2015. At $50, AIG shares are extremely cheap. Moreover, shares are trading at a substantial discount to book value, which will more than negate any decline in AIG's current bond holdings. Yellen is signaling the end of easy money is starting to approach. AIG is the premiere play on a normalization in interest rate policy.

Disclosure: I am long AIG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.